Europe rates seen on hold - for now

Weakening euro may be worth one point rate cut

By

KabirChibber

LONDON (MarketWatch) -- With growing pressure to spark the slow-growing economies of Europe, both the European Central Bank and the Bank of England interest rate decisions on Thursday will attract more attention than usual.

But most analysts say the central banks -- at 7 a.m. Eastern for the Bank of England, and 45 minutes later for the ECB -- won't follow in the footsteps of Sweden's Riksbank and announce rate cuts.

"I don't think the ECB accepts the argument for a rate cut," said Mark Wall, senior European economist at Deutsche Bank.

While there have been concerns about economic growth in the 15-member euro zone - the economy grew at a 0.5% quarterly clip in the first quarter, and the European Union sees 0.3% growth in the second quarter -- recent data show that business confidence is improving.

The Bank of England is also expected to hold its key rate steady, though Wall says there's a "definitive risk" of the U.K. central bank surprising the markets and easing in July.

Weak euro does ECB's job

The ECB is likely to keep rates on hold at 2% for the 25th consecutive month.

Economic sentiment in Germany, Europe's largest economy, improved in June, according to both the influential Ifo and ZEW institutes. And the European Commission's business climate indicator for the euro area rose slightly in the same month, ending the decline that had started at the beginning of the year.

"The euro-zone's economy is stabilizing," Wall said, adding that the value of the euro has fallen substantially against the dollar in the first half of the year, helping European exporters and companies.

The euro has lost 5.7% of its value since March 11.

Wall said the euro's depreciation is equivalent to a fall of between a half point and a full point interest rate cut.

"It suits the ECB for the currency to weaken," added Moyeen Islam, a fixed-income strategist at Barclays Capital. "It does the work for them."

He put the probability of the ECB cutting rates this week at only 20%, and said most investors see the ECB holding rates in the short term.

"The ECB is in a period of super-neutrality," Islam said.

In fact, Wall said the ECB may well be looking at a rate increase as its next natural step. The ECB's interest rate has been at 2% for more than two years.

"If the recovery comes through in the second half, as we expect, then...the ECB could possibly be in a position to tighten monetary policy by the end of the year," Wall said.

Ian Stannard, currency strategist at BNP Paribas, expects euro weakness to continue for the next few months, with markets adjusting to ongoing hikes in U.S. rates by the Federal Reserve.

U.K. rate cut coming...soon

The Bank of England is also expected to hold steady - for now. But many observers predict an easing in August.

The central bank "is unlikely to be long before it starts to loosen monetary policy," said economists at the Royal Bank of Scotland.

"Consumer spending has not recovered as we (and the bank) had expected. In addition, business-investment spending and manufacturing-sector activity have both been disconcertingly sluggish in recent months," RBS added.

Stannard said a surprise rate cut would pressure the British pound. "If rates are held, then I would expect market speculation to intensify for a rate cut in August," he said. Islam said there could be something of a relief rally if rates are not cut this week.

Wall said the Bank of England will update its growth and inflation forecasts on Aug. 10, so holding rates steady now will allow for a "more considered position" on the state of the U.K. economy.

He expects the short-term rate to be at 4.25% by the end of the year.

The market will also be watching to see whether any more members of the U.K.'s rate-setting Monetary Policy Committee will dissent when the minutes are released in two weeks time. The panel voted 7-2 in June, with two members unexpectedly supporting a 25 basis-point reduction in interest rates.

If any more members move towards a rate cut, it would add to pressure on sterling, Stannard said. Sterling has depreciated considerably against the dollar in the past week.

Retailers seen needing cut

Retailer stocks will be among those expected to benefit most from rate cuts. They have been warning of a poor consumer environment since Christmas. The British Retail Consortium said comparable retail sales fell 2.4% over the April to June period.

"There is an urgent need for an early cut in interest rates to prevent a continued decline, especially as it will take several months for a reduction to have any effect," BRC Director General Kevin Hawkins.

Chancellor of the Exchequer Gordon Brown expects the U.K. economy to grow between 3.0% and 3.5% this year, a target most economists and think tanks expect the U.K. economy to miss.

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